Vítor Constâncio: Understanding the driving forces behind systemic financial crises Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the 2011 Bernácer Prize Award Ceremony in honour of Mr Lasse Heje Pedersen, Madrid, 28 June 2012. *

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Ladies and Gentlemen, It is a great pleasure for me to address a few words to you in honour of this year’s winner of the 2011 Bernácer Prize, Professor Lasse Pedersen from New York University. The developments on the global financial markets that we have been witnessing in the past years are unprecedented in nature and have raised a number of challenges for policy makers and central banks alike. In times like these it is more important than ever that we use the advice of the brightest and most talented scholars in order to find answers to complex questions and develop effective tools with real-world applicability in order to combat the potentially adverse effects of financial instability without jeopardizing our primary mandate of medium-term price stability. Without doubt, Lasse Pedersen has been one of the leading minds that have re-shaped our thinking about financial markets, as his contributions during the past decade have greatly improved our understanding of the driving forces behind systemic financial crises and the propagation of liquidity shocks across markets and throughout the economy. Naturally, academic research plays an important role for central banks in general because it provides the foundations for the conduct of monetary policy and its impact on the real economy. The Eurosystem is no exception to this and naturally finds itself in constant exchange with the global research community in the form of research seminars and conferences as well as regular academic visitors. Moreover the ECB regularly funds policy-relevant academic research via the Lamfalussy Fellowship. In 2010, the Eurosystem launched the Macroprudential Research Network MaRs with the objective to develop core conceptual frameworks, models and tools that would provide research support in order to improve macro-prudential supervision in the European Union. Lasse Pedersen’s research focuses on the role of liquidity in financial markets. While much of the classical theory of asset pricing assumes a frictionless world, his work departs from this idealisation and acknowledges that real-world features such as the institutional structure of the way capital is invested around the globe have profound implications for both the determination of asset prices as well as for the stability of the financial system itself. Today, most trade in financial markets – be it stocks, bonds, currencies, or derivatives – does not take place between individuals but rather financial institutions such as banks and investment firms. This has important implications for the functioning of these markets because it introduces several important types of frictions. As we have all witnessed in the past years, many of these entities are very large, at least in terms of their balance sheets. Besides giving rise to the too-big-to-fail problem that has been at the heart of the current financial crisis, the size of these financial institutions has profound implications for the way investment portfolios are constructed and assets are traded, because it makes a large difference whether an agent wants to buy or sell 100 shares or 100,000 shares. For large investors, the impact of their actions on market prices is no longer negligible and they potentially incur large transaction costs due to “market impact”, such that fluctuations in market liquidity – the ease with which a security can be transformed into cash – become a first-order concern. Based on this real-world insight, Acharya and Pedersen

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developed the liquidity adjusted Capital Asset Pricing Model (CAPM),1 which shows that investors do not only require compensation for bearing the risk associated to an asset’s fundamentals but also will command an additiona